Unlimited Possibilities With Limited Liability

There is a relatively new business structure on the block.
While the S corporation remains the most-used type of small business entity,
the limited liability company (LLC) is increasingly the entity of choice for
both new and existing HVACR businesses.

LLCs are popular entities for operating an HVACR business
because, as with any incorporated business, owners have limited liability for
the debts and actions of the LLC. Other features of LLCs are more in line with
a partnership, providing management flexibility and the benefit of pass-through
taxation.

Owners of an LLC are called “members” and since most states
do not restrict ownership, members may include individuals, corporations, other
LLCs and even foreign entities. There is no maximum number of members and most
states also permit “single member” LLCs, those having only one owner. Only a
few types of businesses cannot be LLCs, such as banks, insurance companies, and
nonprofit organizations.

LLC DEFINED

An LLC is a business structure that combines the
pass-through taxation of a partnership or sole proprietorship with the limited
liability of a corporation. As is the case with owners in partnerships or sole
proprietorships, LLC members report business profits or losses on their
personal income tax returns; the LLC itself is not a separate taxable entity.

Like owners of a corporation, however, all LLC owners or
members are protected from personal liability for business debts and claims - a
feature known as “limited liability.” This means that if the business owes
money or faces a lawsuit for some other reason, only the assets of the business
itself are at risk. Creditors usually cannot reach the personal assets of the
LLC members, such as their house or car.

Unlike S corporations, LLCs have no limit on the number or
nationality of members, can own subsidiaries, and can have more than one class
of interest - a good method of unequally dividing income and losses. A limited
liability company (yes, company not corporation) can select varying forms of
distribution for profits. Unlike a common partnership where the split is 50-50,
LLCs have much more flexibility. LLC profits are taxed only once, at the
owners’ tax rate when earned by the entity.

Sound like a partnership? Well, not quite. LLCs protect all
members’ personal assets from debts and lawsuits. Even a limited partnership (LP) has one party who assumes
liability, the general partner, and that partner usually must have substantial
net worth. Furthermore, limited partners who participate in managing the HVACR
business risk losing their limited liability.

VIVA THE DIFFERENCES

Corporations are required to keep formal minutes, have
meetings, and record resolutions. The LLC business structure requires no
corporate minutes or resolutions and is easier to operate. In fact, in some
states, LLCs can be created with just one natural person involved. All business
losses, profits, and expenses flow through the HVACR business to the individual
members. You avoid the double taxation of paying corporate tax and individual
tax. Generally, this will be a tax
advantage, but circumstances can favor a corporate tax structure.

Probably most importantly, owners of an LLC have the
liability protection of a corporation. An LLC exists as a separate entity much
like a corporation. Members cannot be held personally liable for debts unless
they have signed a personal guarantee.

Admittedly, this limited liability is not foolproof. Both
LLC members and corporate shareholders can lose this protection by acting
illegally, unethically, or irresponsibly. Plus, many courts are increasingly
reaching behind the corporate veil into the pockets of members and shareholders
who have not kept the business entity fully separate from their personal
finances.

Other disadvantages include, but are not limited to:

• Limited life. While corporations can
live forever, an LLC is dissolved when a member dies or undergoes bankruptcy.

• Going public. Owners of HVACR
businesses with plans to take their company public, or issuing employee shares
in the future, may be best served by choosing a corporate business structure.

• Raising capital. It may be more
difficult to raise capital for an LLC, as investors may be more comfortable
investing funds in the better-understood corporate form with a view toward an
eventual IPO.

• Complexity. Running a
sole-proprietorship or partnership usually involves less paperwork and is less
complex. Under federal tax laws an LLC may be classified as a
sole-proprietorship, partnership or corporation for tax purposes. Classification
can be made on the tax return thanks to the so-called check-the-box question on
the tax return. If not selected, a default often applies.

Also on the downside, the laws of various states governing
limited liability companies vary - no uniform law prevails, making doing
business in more than one state difficult.

Like partnerships, LLCs do not have perpetual life. Some
states stipulate that the HVACR business must dissolve after 30 or 40 years.
Technically, an LLC venture dissolves whenever a member dies, quits, or
retires.

FORMING THE LLC

In most states, an LLC can be formed simply by filing
‘articles of organization’ with the state’s LLC filing office, usually the
Secretary of State’s office, and paying a filing fee. Many states, in fact,
provide a fill-in-the-blank form that takes only a few minutes to prepare.

The operating agreement, for the most part, contains any
procedures and rules that the parties desire and, once put into place, can just
sit there, maintenance-free. The operating agreement explicitly states the
rights and responsibilities of the LLC members. Without a written LLC operating
agreement, the LLC laws of your state will govern the inner working of the LLC.
Generally, it is preferable to clarify your business arrangements and decide
how your LLC will be run, rather than having the state dictate its terms.

No one needs any more red tape in his or her life. Under the
LLC rules in most states, there is no need to keep exhaustive minutes, hold meetings,
or make resolutions to, in effect, stay legal. This is often a trap for the
unwary and is the first place the IRS or an aggressive attorney will attack
when attempting to “pierce the corporate veil,” and go after the shareholders
personally. If the records are not maintained perfectly, the corporate
protection may be lost.

SWITCHING TO AN LLC

In most situations, an HVACR contractor or business
operating as a partnership can quickly, and inexpensively convert to an LLC.
Partnerships can usually convert without tax consequences, with the new LLC
continuing to file a partnership tax return with the IRS. Because of the
similarity of the structure, the IRS does not usually look at the conversion as
a taxable event.

A corporation can also convert to LLC status, although it
may not be a wise move for the shareholders of many incorporated businesses.
Generally, it is not feasible for an HVACR business operating as a corporation,
either as a regular or as an S corporation, to convert to LLC status. IRS
regulations require that the incorporated business liquidate first, thus
creating considerable tax liability.

To convert, a corporation must first be liquidated and pay
tax on any gain in its fair market value. Even a corporation with depressed
values that converts would have to be prepared to prove its estimate to the
IRS. That could mean a costly appraisal.

As with many good things, there are tax questions
surrounding the use of an LLC to operate the HVACR business. For starters, there
is the Self-Employment Tax Act (SETA). Limited partners and S corporation
shareholders generally are not subject to self-employment taxes - a 2.9 percent
Medicare levy on all salaries and 12.4 percent FICA (Social Security) tax on
income up to $97,500 (in 2007) - but are passive LLC members?

The IRS’s position, subject to change, is that LLC members
who participate in management are subject to employment taxes. If LLC members
are legitimate, passive members, according to the IRS, should not be subject to
those employment taxes.

THE LLC IS OK SOMETIMES

LLCs work for startups, for HVACR operations branching out,
and in lieu of LPs for such financial entities as trading pools and hedge
funds. Lawyers are increasingly recommending them for estate planning;
reorganize assets or the family business as an LLC, and you can gradually give
most of the shares to your heirs while retaining management control.

The LLC is rapidly becoming the entity of choice for many
contractors, business owners, shareholders, and partners in every realm. The
LLC will continue to gain momentum as more and more people learn of its
existence. You might be well advised to consider its many benefits - and its
possible pitfalls - for your HVACR business. Once all of the pros and cons are
considered, many HVACR contractors and business owners have discovered the
so-called limited liability company is the most profitable operating entity.

Publication date: 01/07/2008

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